Have you reported all of your income to the IRS?
If you are being audited by the IRS, be prepared. Almost every IRS auditor is going to want to investigate whether you have reported all of your income on your tax return.
To do this, an IRS audit will conduct what is known as a bank deposit analysis. A bank deposit analysis involves the IRS adding up every deposit in your bank account and comparing it to the income you reported on your tax return.
The IRS will request you to provide the bank statements for the audit; if you do not, they will issue a subpoena to your bank to acquire them.
If your bank deposits are greater than what you reported on your return, the IRS will automatically presume the difference was earned by you and is taxable.
The burden will then shift to you to prove to the IRS that the difference between what is in your bank statements and on your tax return is not taxable. Nontaxable forms of income can include cash gifts, rebates, reimbursements, interbank transfers and loans.
A recent bank deposit audit case I defended involved a client who received a $20,000 cash gift from a grandmother (this type of cash gift is nontaxable). The client kept the cash in a shoebox for 20 years, then finally deposited into it his bank account when he needed operating capital for his business. Of course, as things go, the year it was deposited was the year of the audit.
My client had no direct proof that the money was a gift – his grandmother had since passed away, and the IRS did not believe my client’s explanations, preferring to think the deposit was income earned in my client’s business. The case had to litigated in Tax Court.
In trial, my client gave very specific testimony as to his receipt of the money from his grandmother, where he kept it, and why he chose such a unorthodox method of holding the money. The Tax Court found my client credible and honest, and agreed the money was not earned but was a nontaxable gift and ruled in our favor.
The point is this: defending an IRS audit of your bank deposits requires careful reconstruction of where unearned and nontaxable income came from. It can require affidavits from third parties who provided loans, or obtaining cancelled checks that may have notations on them as to the purpose, i.e. “happy birthday” (yes, the IRS can consider birthday gifts taxable income unless it is proven otherwise).
I do not suggest that any client stop using bank accounts or go to cash; the IRS has ways to attack that, too, and the presumption of operating on all cash can have more criminal-type implications. I have defended many bank deposit audit cases, and success comes from understanding how to recreate records and establish testimony that proves the source of nontaxable income.